Merrill stays behind the analysis curve

MikeTarsala

SAN FRANCISCO (CBS.MW) - Merrill Lynch, the brokerage that still employs analyst Henry "Amazon" Blodget, told clients Tuesday that technology stocks are overvalued, in large part because earnings have been overstated due to accounting rules for the past three years.

In another example of its behind-the-curve analysis, Merrill's tech strategist Steven Milunovich, along with one of the company's outgoing accounting experts, gave their fresh-as used-gym-socks take on tech earnings.

Reported profit in 2000 for a cross-section of 37 tech companies was, on average, 25 percent lower after including stock-option costs and eliminating non-operating items and one-time charges.

"As a result, valuations are higher than investors think," Milunovich said in a research note and subsequent conference call.

Next, Merrill's going to tell its retail customers to sell shares of Pets.com and Webvan. Oh, wait, they did that last year -- after Internet stocks lost more than half their value.

Merrill's recent report offers up yet another example of how its analysts continue to issue after-the fact stock information in an effort to make up for their track record of abysmal calls on tech investments, when it was mainly focused on raking in record investment banking bucks.

"If Steve knew the tech stocks were overvalued, he kept it as secret to his clients and the rest of the world until today," said Michael Boyle, president and chairman of the Boyle Fund in San Francisco.

"I'm sure Merrill took accounting rules into consideration last year, when they had strong buy ratings on stocks that were priced 10 times what they are now. I don' t know which time to believe Steve - now or then."

Merrill's research, no doubt, raises some weighty tech investor complaints - ones voiced by financial journalists over the past few months. But while it casts the tech industry accountants in a negative light, it lays none of the blame at the feet of the financial-stock gurus who blindly accepted the accounting rules. Merrill analysts act as if it didn't occur to them to scrutinize the tall earnings tales many tech companies told until now.

"I don't know that much has changed in the past five years, as far as accounting rules and how companies recognize stock options," Boyle said.

According to Merrill's research, accounting adjustments would have reduced income by more than 100 percent at bellwether tech companies including EBay
EBAY, +1.87%
Juniper Networks
JNPR, -0.70%
Lucent
LU
Siebel Systems
SEBL
and Yahoo
YHOO, +0.85%
to name a few.

The current method of stock-option accounting is the biggest issue with the quality of tech earnings, Merrill points out, as it provided the biggest false boost to technology stocks. Using the "fair value" approach, earnings for the companies Merrill studies would have been 60 percent lower. Yahoo's stock options, in particular, would have reduced earnings 1,878 percent.

The tax benefit companies get when employees exercise their stock options comprised 48 percent of the operating cash flow of the companies Merrill studied. The investment bank is looking for lower operating cash flow overall in 2001, as a lot more of the tax expenses are expected to be a cash payment, compared with past years.

Merrill points out that tech companies in the U.S. almost always appear more profitable than their non-U.S. counterparts. The accounting-method for stock options is a major factor, but another is the write-offs companies take related to "intangibles" and "in-process research and development." That stuff doesn't fly in most European countries.

Last but not least, companies provide very little information about their investment income when they report earnings, Merrill adds. Companies are only required to report equity stakes of 20 percent or more. When large tech companies report hundreds of millions in investment income, it's a "glaring omission," the investment bank concludes. Investments comprised 23 percent of the assets of the companies in 2000.

Is it coincidental that Merrill issues its report now - just days after the entire brokerage industry started to face pressure at the hands of last week's House Capital Markets subcommittee for underwriting, yet hyping stocks?

Hmm ... Doubt it. The company seems to want to present a squeaky clean image to the public, in much the same way the Securities Industry Association hurried out a code of conduct designed to supposedly increase independent analysis last week.

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